Does Fiduciary Duty to Creditors Reduce Debt-Covenant Avoidance Behavior?

Shai Levi is Assistant Professor at Tel Aviv University; Benjamin Segal is Associate Professor at Fordham University; and Dan Segal is Associate Professor of Accounting at the Interdisciplinary Center Herzliya. This post is based on a recent paper by Professors Levi, Segal, and Segal.

Financial reports should provide useful information to both shareholders and creditors, according to U.S. accounting principles. However, directors of corporations have fiduciary duties toward equity holders only. In our paper, Does Fiduciary Duty to Creditors Reduce Debt-Covenant Avoidance Behavior?, we examine whether this slant in corporate governance biases financial reports in favor of equity investors. In particular, we examine whether the likelihood that firms manipulate their reporting to circumvent debt covenants is higher when directors owe fiduciary duties only to equity holders, rather than when they owe fiduciary duties also to creditors. Debt covenants set limits on leverage and performance, and act as a tripwire allowing creditors to take timely actions to reduce bankruptcy risk and costs. When managers manipulate financial reports to circumvent these debt covenants, they transfer wealth from creditors to shareholders.

We use the 1991 Delaware court ruling in the Credit Lyonnais v. Pathe Communications case as a setting to test the effect of directors’ fiduciary duties on the financial reporting of firms. Historically, the position of U.S. courts was that fiduciary duties are owed strictly to equity holders but not to creditors. However, the Delaware court ruled that when a firm is close to insolvency, directors are not merely the agent of the shareholders but should consider the interests of creditors as well. The ruling was widely viewed as having created a new obligation for directors of Delaware firms, and evidence suggests this ruling reduced the debt-equity conflicts in Delaware firms that were close to insolvency (Becker and Stromberg, 2012).

We measure manipulation to avoid covenant violation by the extent and amount of issuance of debt structured as equity. Specifically, we focus on the issuance of mandatory redeemable preferred shares—preferred shares with a debt-like maturity feature that requires issuers to redeem the invested amount by a specific future date. Although the economic substance of these instruments is similar to debt, they were not reported as a liability on the Balance Sheet, and hence, were used by firms to lower their reported leverage and circumvent debt covenants. Using a difference-in-differences analysis around the Credit Lyonnais ruling, we find that following the 1991 Delaware ruling, Delaware firms that were close to insolvency reduced the use of structured transactions designed to evade debt covenant limits. All other firms—Delaware firms with not close to insolvency and firms incorporated elsewhere—did not experience a change in structured debt issuance around 1991. These results suggest that when managers and directors face legal fiduciary duty toward creditors, they are less likely to use structured debt transactions, that is, to take actions to avoid covenant breach.

We also examine the mediating role of board independence on firms’ use of structured transactions designed to circumvent debt covenants. Prior literature shows that board independence is associated with better audit quality, higher reporting quality, and fewer financial reporting frauds and misstatements. We find that board independence improves the quality of reporting from creditors’ perspective, only when directors owe fiduciary duties to creditors. Specifically, we find that board independence is associated with lower structured debt issuances only in Delaware firms that were close to insolvency. We find no relation between board independence and structured debt issuances in non-Delaware firms and low-leverage Delaware firms, where directors are not required to protect creditors’ interests.

Taken together, our study suggests that imposing fiduciary duties toward creditors reduces financial-reporting conflicts between equity and debtholders, and consequently reduces the likelihood of manipulations that favor equity holders’ over creditors’ interests. In addition, while the evidence in the extant literature suggests board quality improves the quality of financial reporting unconditionally, our evidence suggests board quality improves financial-reporting quality for the stakeholder to whom directors owe fiduciary duties. Firms with high board quality that do not owe fiduciary duties to creditors are as likely to take actions to circumvent covenant breach as firms with low board quality. However, when firms owe fiduciary duties to creditors, governance quality is negatively associated with the likelihood that the firms take such actions.

The complete paper is available for download here.

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